Mortgage meltdown leads E-Trade to $58 million loss

MurrayColeman

SAN FRANCISCO (MarketWatch) -- Despite record trading activity and asset growth, write-offs of mortgages and related home equity loans led E-Trade Financial Corp. Wednesday to report a third quarter loss of $58 million.

The loss, which was equivalent to 14 cents per share, compared to net income of $153 million, or 35 cents a share, in the year-earlier period.

A consensus estimate of five analysts compiled by Thomson Financial expected E-Trade
ETFC, +0.07%
to generate $41.9 million, or 10 cents a share, in profits.

"People are probably surprised that a company like E-Trade is being snared in this mortgage crisis," said Chip Hanlon, president at Delta Global Advisors Inc. in Huntington Beach, Calif. "This could fuel fear that the real estate mess isn't close to being over."

Shares of E-Trade finished down nearly 1.8% in Wednesday's session. In after-hours trading about an hour after the market's close, shares dropped 4%.

E-Trade had warned last month that it was being heavily impacted in the quarter by adverse mortgage-related conditions. The company pointed at the time to a potentially large hit in earnings.

"This is very frustrating for us," said Jarrett Lilien, E-Trade's president. "We had the best quarter ever in our core business. But events in the credit markets overshadowed those gains."

In a conference call with analysts and investors after markets closed, E-Trade lowered its full-year projections. It now says earnings should wind up somewhere in a range of 75 cents to 90 cents a share. The Street was projecting around $1.11 per share, according to Thomson.

For the fourth quarter, E-Trade executives say they're now expecting earnings of 13 cents to 28 cents per share. The consensus was about 25 cents per share.

"It's a market in flux," Lilien said during the conference.

E-Trade had some $29.7 billion of mortgage loans that were considered high-quality on its balance sheet by quarter's end. Another $3 billion in loans were consumer loans. Margin loans to customers represented another $7.7 billion.

All were what Lilien characterized as high-quality loans with high underwriting and collateral standards.

"A lot of people think that subprime loans is where the problems center," he said. "But that's not our problem. Our issue is that the value of high-quality loans is underperforming."

E-Trade says its issues in the quarter were with home-equity lines and home-installment loans. "That's where we're seeing worse performance," Lilien said.

Loans are considered nonperforming once payments are late by 90 days or more. "So you create a reserve to cover any loans that might go past-due," Lilien said.

E-Trade took $187 million one-time provisions in the quarter to cover nonperforming loans. Part of those provisions included some $53 million in charge-offs. That left E-Trade with a total of $209 million in reserves for future loan losses.

"Right now, our allowance for loan losses is now 116% of nonperforming loans in the second-lien portfolio, where we've been seeing trouble," Lilien added. "The result is that we've moved very conservatively to create enough of a reserve to cover what's happening in the market."

E-Trade also wrote down about $200 million in asset-backed securities. "That pretty much took the most risky types of assets off the table," Lilien said.

The mortgage meltdown came as E-Trade's retail segment produced record revenue of $474 million in its third quarter. Retail client assets rose 18% from the same period a year ago to a record $218 billion. That included a 25% increase in total customer cash and deposits.

Daily average revenue trades, or DARTs, rose 44% from a year earlier to a third-quarter record of 194,000.

"While we are extremely pleased with the continued growth trends we are generating throughout the retail business, we are clearly disappointed with the overall company performance as a result of the severe volatility in the credit markets," said Mitchell Caplan, E-Trade's chief executive, in a statement.

He added: "We are working diligently to execute our strategic plan to manage through the credit challenges as quickly as possible and focus the company on the opportunity and strength of our retail franchise."

Although the company warned in mid-September it was getting out of the wholesale mortgage business and would take restructuring and securities-related charges, Morningstar Inc.'s Patrick O'Shaughnessy says conditions proved to be worse than expected.

Instead of E-Trade's early estimate of $132 million in losses, the Chicago-based analyst pointed out that it wound up taking $197 million in mortgage and other asset-backed securities-related write-offs in the quarter.

"What they essentially did was peel-off a Band-Aid once instead of over a longer period of time. So they took a big hit now instead of later," O'Shaughnessy said.

That should help their earnings growth going forward, he added. "They're not going to get out of mortgages entirely. But they're going to rely on their own bank to underwrite mortgages," O'Shaughnessy said. "That's a safer way to go since they know a lot more about their own customers than third-party clients."

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